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Introduction

On 7 July 2010, the European Parliament voted in favour of a proposed Directive which will amend the revised Capital Requirements Directive. This proposed Directive has become known as CRD III and has hit the headlines because, among other things, it will require institutions to implement certain remuneration policies and practices that are consistent with effective risk management. In particular the proposed new rules cover the structure, amount and timing of bonus payments.

How will the changes be implemented?

The new remuneration rules will be introduced by amending Annex 5 of Directive 2006/48/EC (the Banking Consolidation Directive), which relates to the taking up and pursuit of the business of credit institutions. Under Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions (the Capital Requirements Directive or CRD), Annex 5 of the Banking Consolidation Directive also applies to investment firms regulated by the Markets in Financial Instruments Directive (MiFID).

It will be the responsibility of individual Member States to implement policies consistent with the remuneration rules in CRD III. In the UK, the Financial Services Act 2010 already gives the FSA powers to regulate remuneration policies. CRD III is likely to be implemented by way of an amendment and extension of the FSA’s remuneration code.

Which institutions are covered by the new remuneration rules?

The remuneration policies set out in CRD III apply to a broad scope of institutions.

In the recitals of the text of the Directive adopted by the European Parliament it is stated that the new rules will apply to all credit institutions and to investment firms falling within the scope of MiFID.

In addition institutions are to apply the new rules at the group, parent company and subsidiary levels including those established in offshore financial centres.

Key requirements

The proposed Directive sets out certain principles that institutions’ remuneration policies should comply with including:

Upfront cash bonuses will be capped at 30% of the total bonus and 20% for particularly large bonuses

At least 40% of any bonus must be deferred for a period not less than 3 to 5 years and must be recoverable if investments do not perform as expected. In the case of a variable remuneration component of a particularly high amount, at least 60% must be deferred

At least 50% of the total bonus must consist of an appropriate balance of:

“capital contingent” instruments (funds that can be called upon first in case of institution difficulties)

Variable remuneration, including the deferral portion, should be paid or vest only if it is sustainable according to the financial situation of the institution as a whole, and justified according to the performance of the institution, the business unit and the individual concerned. The total variable remuneration should be ‘considerably contracted’ where subdued or negative performance of the institution occurs, including through ‘malus’ or claw back arrangements

The fixed and variable components of remuneration should be appropriately balanced. The fixed component should represent a sufficiently high proportion of total remuneration to allow the operation of a flexible policy on variable remuneration, including the possibility to pay no variable remuneration component

Guaranteed variable remuneration should be exceptional and occur only in the context of hiring new staff and be limited to the first year

Payments related to the early termination of a contract must reflect performance achieved over time and should be designed in a way that does not reward failure

If an employee leaves the institution before retirement, discretionary pension payments should be held by the institution for a period of five years in the form of shares or share-linked instruments (or equivalent) or capital contingent instruments. Discretionary pension benefits paid to employees reaching retirement should also be paid in this form, subject to a five year retention period

Staff must undertake not to use personal hedging strategies or remuneration- and liability-related insurance to undermine risk alignment effects embedded in their remuneration arrangements. Furthermore, variable remuneration must not be paid through vehicles that facilitate the avoidance of the CRD III remuneration rules

Institutions that are significant in terms of their size, internal organisation and the nature, scope and complexity of their activities must also establish a remuneration committee.

In the case of institutions that have benefited from exceptional government intervention:

Variable remuneration is strictly limited as a percentage of net revenues when it is inconsistent with the maintenance of a sound capital base and timely exit from government support

Institutions must restructure compensation in a manner aligned with sound risk management and long-term growth, including establishing limits on the remuneration of directors where appropriate

No variable remuneration should be paid to the directors of the institution unless it is justified.

Who decides what constitutes a “large” bonus?

It will be the responsibility of national supervisory authorities to decide what constitutes a “large” bonus. However, their decisions must be based on EU guidelines, which will be established by the Committee of European Banking Supervisors (CEBS). Once the European Banking Authority (EBA) replaces CEBS, the national authorities’ decisions will be based on EBA’s technical standards.

Which individuals are covered by the remuneration rules?

The rules will apply to senior management, risk takers, controller functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers. The Commission’s intention is that the rules apply to anyone whose professional activities have a material impact on the institution’s risk profile.

There is some concern that junior employees will be hit the hardest. Top earners receiving the largest bonuses already receive a large proportion in deferred payments, while junior employees receiving smaller bonuses may be paid the total in cash. An additional knock-on effect is that top earners will benefit from remuneration deferred in previous years, which junior employees receiving cash bonuses will not have built up.

Proportionality

The Commission recognises that “credit institutions and investment firms may apply the provisions in different ways according to their size, internal organisation and the nature, scope and complexity of their activities”. Furthermore, CRD III states that it may not be “proportionate” for certain types of investment firm “to comply with all of the principles”.

Uncertainty remains as to the meaning of this proportionality clause. The Investment Management Association asserts that this “acknowledges that asset managers may not have to meet all the detailed requirements on remuneration” and argues that this is “recognition of the fact that the same systemic issues do not apply to investment managers, since the business model is different from banks”.

This may potentially allow hedge fund managers and other investment firms with a small amount of assets under management to escape the application of the remuneration rules under the revised CRD. However, ultimately this issue will turn on how national regulators interpret the proportionality clause.

How do these amendments relate to other EU initiatives? Is there the possibility of regulatory overlap?

CRD III is not the only EU initiative that will apply to investment firms. The EU is also currently developing the Alternative Investment Fund Managers Directive (AIFM) and the UCITS IV package for UCITS managers. Both of these initiatives aim to tighten risk management policy in relation to remuneration.

While the European Commission may consult on harmonisation of the EU remuneration rules, there is a possibility that some fund managers will be subject to double or even triple regulation on the subject of remuneration. The extent of this regulatory overlap will not be clear until all three initiatives have been finalised.

Competition concerns

There is widespread market concern that the new remuneration rules will place EU-based credit institutions and investment firms at a competitive disadvantage. Stuart Fraser, policy chairman of the City of London Corporation, argues that “If the G20 countries based outside the EU fail to implement equivalent regimes these rules will have little impact in terms of eliminating risk-taking and will have a hugely detrimental impact upon our international competitiveness.”

The application of the remuneration rules to hedge fund managers has attracted particular criticism, especially in the City of London where 80 per cent of the EU hedge fund industry is based. This discontent has been amplified in light of the general recognition that remuneration in the hedge fund industry was not a cause of the current financial crisis. There has been some speculation that the new rules could cause hedge funds to relocate to Asia or Switzerland, where the remuneration regime may be more favourable.

Antonio Borges, chairman of the Hedge Fund Standards Board, warns that “European hostility towards hedge funds may have unintended consequences, some of them the exact opposite of what European politicians say they want.” Borges argues that there is “a risk that specific regulatory provisions and interventions could create havoc in the industry and make life very difficult for managers and investors.” This, Borges suggests, is an example of how “misguided policies can put Europe at a great disadvantage in a financial world which is more and more global.”

The true extent of the impact on the competitiveness of EU institutions may depend upon many factors, including:

The manner in which CRD III is implemented by national authorities

The degree of flexibility available in the application of the remuneration principles to different types of institution

The application of the proportionality principle by national authorities

The impact of other EU initiatives, such as the AIFM Directive

The relative advantages and disadvantages for institutions relocating to other jurisdictions.

Which bonuses will be covered?

The remuneration rules will apply retrospectively. The provisions will apply to remuneration that is awarded or paid after the implementation date on the basis of contracts concluded before that date. The rules will also apply to remuneration awarded, but not yet paid, before the implementation date, for services provided in 2010.

What are the next steps?

At the time of writing this update the CRD III still needs to be approved by the Council. The rules on bonus provisions are expected to take effect in January 2011. The rules on capital requirements are expected to take effect no later than 31 December 2011.